When entrepreneurs and venture capitalists sit down to discuss financing, they often set ownership percentages based on "pre-money" (the amount the firm is worth before the VC investment) and "post-money" valuations. The VC's share will often depend upon the ratio of its investment to the pre-money value of the business.

This is the wrong way to go about things, argue the authors of a new paper, Effective vs. Nominal Valuations in Venture Capital Investing, forthcoming in the New York University Journal of Law and Business. Michael Woronoff, a partner at Proskauer Rose and lecturer at UCLA, and Jonathan Rosen of Shelter Capital argue that negotiators should focus not on how much the business is worth now, but on how much each will get upon exit. Here's the abstract:

Any serious conversation between venture capitalist and entrepreneur ultimately leads to the issue of valuation of the enterprise. The discussions typically focus on some combination of pre-money value, the amount of capital being raised, and post-money value.

In turn, these values may be used to calculate a percentage of the company being sold. The entrepreneur will typically use these amounts to compare offers from different investors, or in the absence of multiple offers, as one of the primary items of negotiation.

The focus on the nominal pre-money and post-money value and ownership percentage, though common, is misguided. All parties would be better served by focusing on the actual value that will flow to each party upon a monetization event (or exit), which will be only partially dependent upon the percentage ownership implied by the pre- and post-money valuation contained in the term sheet. As obvious as this advice may seem, it typically goes unmentioned in even sophisticated discussions of the valuation of venture capital deals. Indeed, some actually counsel against this advice, arguing that cash flows are not significantly affected by factors other than price, so these other factors should not be overemphasized.

This Article explores how the structure of the typical venture capital transaction can significantly affect the distribution of value among various interested parties upon exit.